FACTORING

Meaning of Factoring

Factoring is a financial service, which involves

Meaning,

Financing and

Collecting receivable

It is both a financial as well as management support to supplier of goods/services. It is a method of converting non-productive assets (receivables into productive assets (Cash). A factor makes the conversion of receivables into cash possible.

Factoring may be defined as a contract between the supplier of goods/services and the factor under which the factor agrees to perform atleast two of the following functions :

(a) To finance the assigned book debts (receivables).

(b) To maintain account relating to receivables.

(c) To collect book debts.

(d) To provide protection against default in payment by debtors.

(e) To provide credit administration services to the clients to decide whether or not and how much credit should be extended to the customers. some of the major factoring firms in India are

SBI Factors and Commercial Services Ltd

Canara bank Factors Ltd. (1991),

Fair Growth Factors Ltd. (1992).

Factoring Commission-The commission charges by the factor for providing factoring services is known as factoring commission. It is usually expressed as a percentage of face value of receivables factored. In India, it ranges between 2.5 to 3 per cent. The commission is expect to be lower for recourse factoring since the factor does not assume the risk of bad debts. The commission is expected to be higher for non-recourse factoring since the factor assumes the risk of bad debts.

Types of Factoring

The factoring services may be classified under following categories:

1. Non-recourse Factoring —(Old Line Factoring)—Under Non-recourse factoring factor assumes the risk of bad debts and charges higher commission for and advances cash up to 80/90% of book debts immediately.

2. Recourse Factoring—Under recourse factoring, factor does not assumes the risk of bad debts and charges lower commission for and advances cash upto 70/80% of book debts.

3. Advance Factoring—Under advance factoring, factor advances cash against the book debts due to client immediately.

4. Maturity Factoring—Under maturity factoring, the factor makes the payment on maturity (i.e., in case of non-recourse factoring on collection of book debts or on insolvency of customers, in case of recourse factoring on collection of book debts form customers).

5. Finance Factoring (Bulk/agency Factoring)—Under finance factoring, the factor simply finances the book debts against bulk either on recourse or without recourse and the client continues to administer and operate sales ledger.

Non-Notification Factoring—Under non-notification factoring, the notice of assignment of receivables is not given to the debtors. But the factor performs all his functions without a disclosure to the customer that he owns the book debts.

Nature of Obligation of factors

The nature of the obligation of the factor is of bailment contract.

Factor stands in a fiduciary relationship with the client firm and the main responsibility arises out of

the terms of the contract or agreement between the parties. Factoring firms are professionally competent with skilled persons to handle credit sales realizations of different clients in different trades for better credit management.

Need for Factor Services

Need for factor services is felt by traders to concentrate on sales and realization credit sales be left in specialized hands to minimize the risk of bad debts arising account of non-realisation of credit sales. If sales are realized within reasona; time, the traders need not depend much for bank finance toward scorching caffc

Parties to Factoring Contract

There are three parties involved generally in a factoring contract as follows:

1. Buyer of goods who has to pay for goods bought on credit terms.

2. Seller of goods who has to realize credit sales from buyer.

3. Factor who acts as agent in realizing credit sales from buyer and passes-the realized sum to seller after deducting his commission,

Factoring Operating Cycle

The factoring operating cycle comprises of the following seven steps :

Step 1 : Buyer negotiates terms of purchasing plant and machinery or other m

with the seller.Step 2 : The factor enters into agreement with seller for rendering factor services M

Step 3 -.Seller delivers goods along with copies of invoice, delivery challan, instructions to make payment to factor to buyer.

Step 4 : Seller sends a deed of assignment in favour of factor alongwith copies sales documents.

Step 5 : On receipt of copies of sales documents as referred to above the ft makes payment to the seller of the 80% or more of the price ol debt.

Step 6 ; Buyer makes payment to the factor in time or gets extension of time or* case of default is subject to legal process at the hands of factor.

Step 7 : The factor receives payment from the buyer on due dates and re money to seller after usual deduction.

Advantages of Factoring

The advantages resulting from the factoring are as follow :

1. Eliminating of trade discounts.

2. Prompt payments and credits.

3. Improves scope for operating leverage.

4. Reduction of administrative cost of burden.

5. Increase in return to the client.

6. Improvement in liquidity.

7. Provides insurance against bad debts.

8. It is neither a loan nor a deposit but facilitates liquidity.

9. It avoids increased debts.

10. Current assets are efficiently managed thus reducing working capital requirements.

11. Better credit discipline amongst customers by regular realization of dues, effective control of sales journal, reduced credit risk, better working capital management etc.

Disadvantages of Factoring

The disadvantages of factoring are as follows :

1. Image of the client may suffer as engaging of a Factoring Agency is not considered a good sign of efficient management.

2. Factoring may not be of much use where companies have nation-wide network branches.

3. Financial evaluation may not be accurate.

4. If the client has cheaper means of finance and credit (where goods are sold against advance payment) factoring may not be useful.

How to decide whether or not to engage a Factor

To decide whether or not to engage a factor, the cost of benefits of factoring should be evaluated. The cost of factoring includes :

(a) Factoring commission;

(ft) Interest on advance granted by the factor;

The benefits of factoring includes :

(a) Saving in cost of In House Credit Collection Department.

(6) Saving in Bad Debt Losses.

Saving in Cost of Funds invested in receivables, should engage a factor if the benefits exceeds the cost otherwise not.

Statement showing the Evaluation of Factoring Arrangement

A. Annual Benefits of Factoring to the Firm :

Credit Administration Cost avoided

Bad debts avoided

Interest saved due to reduction in Average collection Period

B. Annual Cost of Factoring to the Firm :

Factoring Commission

Interest charged by Factor on advance

(Annual Credit sales- Factoring Commission-Factoring Reserve)*

Collection PD* Rate of interest 365

Net Annual Benefits/Cost of Factoring to the Firm : [A ~ B]

Rate of Effective Cost of Factoring to the Firm

= (Net Annual Cost of Factoring to the Firm x 100 Actual Advance granted

Recommendation: The company should adopt the Non-recourse Facto alternative since the Rate of Effective Cost of Factoring to the Firm (i.e. 8%t is less than the existing cost of borrowing (i.e. 15% say).

or

Recommendation : The company should adopt the Non-recourse Fact alternative since it results in Net Annual Benefits of Rs. 5.4 lakhs (say)

or

Recommendation : The company should not adopt the Non-recourse Facto alternative since the Rate of Effective Cost of Factoring to the Firm (i.e. 13%| is more than the existing cost of borrowing (i.e. 12% say),